ETF Structure and Advantage
August 9, 2009
Exchange traded funds (ETFs) in their basic form are baskets of securities that are traded, like individual
stocks, on an exchange. Funds can track any number of
indexes from the large-cap
S&P 500, small-cap Russell 2000, or even commodities. Most of ETFs on the market currently are passively managed, tracking a wide variety of broad to narrow market indexes.
As of July, SPDR (SPY) remains the largest ETF at US$69-billion. SPDR Trust is an exchange-traded fund that holds all of the S&P 500 Index stocks.
Exchange traded funds have grown rapidly to cover most broad investment purchases and many niche markets. Funds that drill down into specific sectors, industries, regions, countries, and asset classes make up a great percentage of the ETF universe, offering relatively inexpensive access to investments such as currencies, precious metals, or emergent industries that thus far have been the sole province of larger institutional and wealthy investors.
Recently, fund companies have also launched actively managed ETFs. These funds are not tied to a benchmark, but continue to sport the familiar benefits of ETFs.
ETFs attract both investors and traders who do not wish to make individual stock selections but only capture the broad movement of the market. ETFs appeal to different types of do-it-yourself investors. Investors who prefer index funds over actively managed offerings find ETFs appealing because many of them are very cheap. Some day-traders like ETFs because of their stock-like qualities and their focus on individual sectors or markets.
ETF Creation
A sponsor, usually a major bank or investment bank will purchase the necessary portfolio of stocks (after registering the new issue on a major exchange and the Securities and Exchange Commission) and deposit them with a trustee. The trustee will then keep the securities and give the bank ETF certificates (which are like certificates of participation) for the securities sold.
The bank or broker will then market the new securities to investors and make a market in the security. The broker makes money from the collection of stock sold into the trust and resold as an ETF. When the sale of the stock is made to the public, it is priced slightly above its liquidation value or net asset value.
Typically less than .35 percent of the portfolio is liquidated to pay institutional expenses like the trustee and exchange and regulatory fees. These fees are apportioned on a daily basis and generally accrue quarterly.
Basic Structure of an ETF
ETFs often look similar to an index
mutual fund, but there are some important differences.
The process of buying and selling ETFs works differently than with mutual funds. ETFs trade like individual stocks. You can purchase them in real time at any point during the day, unlike mutual funds, which settle only at the day's close. This means you can use trading features like stop losses on an ETF that you can't use on an open-end mutual fund.
There are no redemption fees on ETFs, unlike on many of their mutual-fund, but investors do pay a transaction fee to their broker every time they buy or sell shares.
Because ETFs are traded among market participants, ETFs have two prices:
A net asset value (NAV), which represents the intrinsic value of the ETF shares, is set daily based on the ending value of its portfolio and accrued expenses, just like a traditional fund. The NAV is equal to a fund’s assets less its liabilities. The NAV is given per ETF share that is outstanding by dividing the total value of the fund by the number of shares that are issued and outstanding.
A share price, which is determined by the ETF's supply/demand profile in the market, just like a stock. However, spreads between the NAV and the price on the market are usually close because of the intervention of professional investors or "arbitrageurs" that will step in to take advantage of any premiums or discounts to the underlying value by either creating ETF shares and selling them on the market when they trade at a premium or by redeeming ETF shares and selling the underlying stocks when the ETF shares trade at a discount.
To a large extent, the supply and demand for ETF shares is driven by the underlying values of their portfolios, but other factors can and do affect their market prices. As a result, the potential exists for ETFs to trade at prices above or below the value of their underlying portfolios. However, a special process that allows large investors to take advantage of this price differential should, in theory, help prevent sustained discounts or premiums from opening up.
ETFs Advantages
ETFs should have appeal for cost-conscious investors who don't trade frequently. On average, ETFs have a noticeable expense ratio advantage over the typical passive and actively managed mutual funds. Because ETFs trade on an exchange, transactions occur directly between investors, meaning ETF providers don't have to manage hundreds of customer accounts or staff call centers--lowering overhead and, by extension, expense ratios.
On the cost front, an ETF will often be the most cost-effective choice for those who use discount brokers, invest a large lump sum of money, and are willing to hold the investment for the long term. For all others, an exchange-traded fund isn't likely to have a big cost advantage over a plain-vanilla, low-cost index fund.
ETFs may hold a special attraction for investors in taxable accounts. ETFs are tax efficient. They are immune from the tax consequences due to the accumulation of trading profits and losses on both a short term and long term basis that mutual funds suffer. With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions.
Furthermore, redemptions made by large investors are paid in kind, again protecting shareholders from taxable events. All of this should make ETFs more tax-efficient than most mutual funds. Keep in mind, however, that ETFs can and do make capital-gains distributions, as they must still buy and sell stocks to adjust for changes to their underlying benchmarks.
The ETF universe is flush with options that focus on a single market sector, industry, or geographic region. This means that exchange-traded funds can offer a way to invest in a corner of the market without having to load up on just one or two individual stocks. If you're inclined to invest in more-focused ETFs, it makes sense to be a contrarian, not to chase what's been hot recently. Some day-traders like ETFs because they can find ETFs that focus on individual sectors or markets while they have stock-like qualities.
ETFs Disadvantage
While ETFs' low expense is one of their key benefits, the fact remains that if you invest regular sums of money, you'll actually end up costing yourself far more with an ETF than you would with many mutual funds. You pay a brokerage commission each time you buy and sell an ETF, so your costs mount with each trade. Commissions can add up quickly, so if you plan to make periodic investments over time, your overall costs could be lower with a no-load mutual fund.
Using ETFs as tools for short-term speculation negates two of their best features: low costs and tax efficiency. If you trade frequently, brokerage commissions can add up fast, thereby eroding the ETF's low-cost advantage. Quick trades also trigger tax consequences, which can be particularly onerous if you hold an ETF for less than a year and incur the higher short-term capital gains rate. So to benefit from ETFs' best features, avoid the quick-trading crowd and adopt a disciplined, long-term mind set instead.
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